Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk Approach

Sixth Edition

Chapter 15

Audit of Acquisitions, Related Entity

Transactions, Long-Term Liabilities, and Equity

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Mergers and Acquisitions

There are three valuation issues associated

with acquisitions:

Valuing the assets and associate liabilities

upon acquisition

Measuring restructuring charges and

recognition of the liability

Measuring impairment of assets after

operation begins

Acquisition - Asset Valuation Issues

Major issues associated with valuing an

acquisition are:

Determining the cost of the acquisition

Valuing identifiable tangible and

intangible assets and liabilities

Valuing goodwill

Determining the Cost of the Acquisition

Normally, cost is amount paid to acquire the company

However, there are things that make the assessment more complicated: Acquisitions made using stock rather than cash

Where the final price is contingent on the assets received (post-audit)

Where the final price is contingent on acquired entity's performance

Auditor must assess likelihood of acquired entity meeting performance objectives - if highly likely, the full cost should be recognized at the time of acquisition

Valuing Identifiable Tangible & Intangible Assets & Liabilities

Acquiring company records assets at their fair market value at time of acquisition: Company usually hires appraiser to value tangible assets Intangibles should be valued at net present value of future cash

flows Auditor cannot simply accept appraisal and management's

assessment of fair value of assets Auditor must gather independent evidence to determine whether

assessed values are appropriate

Auditor may rely on the specialist hired by management or hire their own specialist. Either way, the auditor should: Evaluate qualifications of the specialist Determine if specialist is independent of management Review the methodology used by the specialist

How do you value goodwill?

Goodwill is the excess of purchase cost over the fair market value of tangible and intangible assets acquired in a purchase

SFAS 142 requires goodwill be specifically identified with an operating or reporting unitImportant so goodwill can be tested for

impairment on an annual basisValuation and testing of impairment is

facilitated if company uses capital budgeting process

Restructuring Charges

When companies restructure operations, GAAP requires companies

recognize the cost of restructuring and associated liabilities

The auditor should examine restructuring charges though these

procedures: Review FASB pronouncements and EITF statements

Review how company estimated restructuring charges

Review actions taken by management that indicate restructuring has

moved beyond a plan

Test estimates by reviewing contracts, property appraisals, severance

contracts, and other restructuring documents

Mathematically test estimates

Develop conclusion as to reasonableness of liability and appropriateness

of client accounting

Testing for Goodwill Impairment

GAAP requires goodwill must be tested every year for impairment

The company must determine the fair market value of the reporting unit and compare it to the reporting unit's carrying value (including goodwill) If fair market value is less than carrying value, it is inferred that

goodwill has been impaired and must be written down The reporting unit may be the company or a sub-unit of the

company

The auditor must evaluate: Management's methodology for assessing impairment Whether an objective evaluation supports the client's conclusion

Annual Audits: Risk Factors and Goodwill Impairment

In addition to the annual review, situations may arise which impair goodwill: Significant adverse change in legal factors or the business

environment Adverse action or assessment by regulator Unanticipated competition that significantly reduces value of

company's products Significant loss of key personnel Expectation that reporting unit will be disposed of Significant asset group within a reporting unit tested for

recoverability Impairment recognized by subsidiary

Audit tests for goodwill impairment will require considerable judgment and business knowledge

Transactions withRelated Parties

Related party transactions have been used to manipulate financial reporting and should, therefore, be considered high risk

Auditor must consider that a client may not want to have its related party transactions discovered

To uncover these transactions, the auditor will: Obtain a list of all related parties; then develop a list of all

transactions with those parties Carefully examine all unusual transactions to determine whether

the transactions involved a related party

The auditor then investigates the transactions to determine if they have been properly recorded and disclosed

Audits of Long-Term Liabilities and Owners Equity

Liabilities with significant subjective judgments:

Restructuring reserves

Warranty reserves

Pension obligations

Other post-retirement benefits

Warranty Reserves

The warranty reserve represents expected future cost related to sales of a company's product; it is estimated and recorded when the product is sold

The estimate is typically based on past experience of the company and adjusted for Changes in the product, including those that change its quality Changes in the warranty Changes in sales volume Changes in the average cost of repairing products under

warranty

The auditor can examine the account by Testing the information system used by the client Developing an estimate based on the factors above

Pension Obligations

The amount of pension obligations are based on a number factors:Estimated lifetime of pensionersFuture earnings of employees prior to retiringEarnings rate on invested pension assetsLong-term interest rates used to discount future costsChanges in pension plans

The client will usually hire an actuarial firm to help make the estimates

The auditor must determine that the actuarial firm is independent, competent, and has sufficient reliable information to develop the estimates

Bonds and Stockholders' Equity

Companies issue capital stock (equity) and bonds (borrowing) to raise long-term funds

Other financing activity accounts include: Notes payable

Mortgages payable

Contracts payable

Special bondsPayment-in- kind bonds

Convertible bonds

Mandatory redeemable preferred stock

Stock options and warrants

Stock options - employee stock compensation program

Auditing Bonds Payable

Bonds are issued to finance major expansions or refinance existing debt. While bond issues are infrequent, each transaction is material

Primary considerations in auditing bonds or other long-term debt:Valuation and amortization of premium or discount

Auditor will review loan documentsIf debt is issued during the audit period, receipt of cash may

be traced to cash receipts journal and bankPrincipal payments may be traced to the disbursements

journalAuditor may confirm year-end balances with debt holders

Computation of interest expenseAuditor will usually recalculate interest expense

including amortization of any discount or premium

Accounting for gains or losses on debt

refinancing

Disclosure of major restrictions in bond

indenturesAuditor typically reviews loan documents and makes

inquiries of client

Auditing Bonds Payable (continued)

Common Stock and Owners' Equity

Transactions affecting stockholders' equity:New stock issuesTreasury stock transactionsDeclaration and issuance of stock dividends

or splitsDeclaration and payment of cash dividendsDonated capitalTransactions involving retained earningsPrior period adjustments

Common Stock and Owners' Equity: Audit Procedures

Since most equity transactions require Board approval, auditor should review the minutes of Board meetings for approval and intent

Valuation of equity transactions is fairly straight forward, except when shares are issued for non-cash assets

Disclosure items: Number of shares of stock authorized, issued, and outstanding

Stock options and warrants

Any significant stock features like convertible feature

Appropriations of retained earnings

Prior period adjustments